Taxing talent

Three decades ago, the corporate income tax rate stood at 48 percent in the average OECD country. Last year it had shrunk to merely 26 percent. This dramatic shift has partially been driven by an increased awareness that lower taxes are beneficial to economic development. It can also be understood in light of increasing globalization and financial liberalization. Governments have reduced taxes on capital to prevent relocation of domestic investments and, equally important, to attract foreign capital, entrepreneurs and job opportunities. 

Charlie McCreevy, former Irish Minister for Finance, oversaw the reduction of the country’s corporate tax rate from 36 to 12.5 percent. In his words:

“It is clear, that other things being equal, investment will flow to where after tax returns are highest, and jobs will be created where investment is highest.”

We argue that the same logic increasingly applies to individual income taxation. In a knowledge intensive economy, where talents are mobile across borders, it makes sense to reduce taxation on labor – particularly amongst highly skilled individuals. Not least the U.S., which has historically benefited from the ability to attract both investments and talents, risks falling behind if the current political course continues.

Today, an abundance of physical capital is seldom enough to stay competitive. An adequate management of human capital is often equally, and sometimes even more, important. This is clearly true of WhatsApp, the messaging subscription service that Facebook recently bought for $19 billion. Although the service has quickly expanded to some 450 million active users, it is merely run by 32 software engineers. Also in traditional businesses, such as manufacturing or food processing, we are seeing that the ingenuity and skills of entrepreneurs and key staff often make the difference between success and failure.

The share of the population with a higher degree is increasing in most advanced economies. Still, many businesses have a hard time finding the right skills on the domestic labor market. The 2013 Talent Shortage Survey, published by the Manpower Group, surveyed more than 38,000 employees worldwide. Over a third reported that they experience difficulties filling positions due to lack of available talents.

On a global level, the demand for skilled trade workers, engineers, sales representatives, technicians, account and finance staff, etc., is significantly larger than the supply. As a result, many firms are looking at attracting skilled labor from abroad. Regional and national governments are likewise focusing on reforms which can increase attractiveness in the global talent market.

Some countries, such as Canada, Australia and New Zealand, have introduced point based systems for labor migration, which make it easier for highly skilled workers to gain entry. Other countries have chosen an even more liberal approach to labor immigration. Sweden, for instance, implemented a new law in 2008, according to which basically anyone with a work contract – and a wage above the effective minimum wage – is guaranteed a work permit.

However, a growing body of research shows that a liberal approach to immigration should be combined with sound financial incentives in order to efficiently attract highly skilled workers from abroad. This is illustrated in an econometric analysis of labor income taxation and migration flows between 49 economies by the German economists Peter Egger and Doina Maria Radulescu. The authors show that skilled workers are less likely to migrate to a country if income tax rates, and in particular top income tax rates, are relatively high compared to their country of origin.

The relationship between tax rates and migration choice also applies to athletes. In a research paper, published in the American Economic Review last fall, Henrik Jacobsen Kleven, Camille Landais and Emmanuel Saez analyze the effects of top tax rates on migration of soccer players in 14 European countries since 1985. The researchers find evidence of strong mobility responses to tax rates among soccer players, and this is particularly true among high-ability players. The talents seek countries with lower taxes, and avoid those with higher rates.

An interesting case study in the world of soccer is to be found in the so-called Beckham Law, which was implemented by the Spanish parliament in 2005. The decree gives highly skilled foreigners, who have not resided in Spain during the past ten years, the right to apply for a 25 percent flat income tax instead of the progressive tax rates that can be as high as 52 percent.

One of the first highly skilled workers to take advantage of the decree was the British soccer superstar David Beckham, who had relocated to Real Madrid from Manchester United – hence the law’s nickname. In the immediate aftermath of the law change, the share of foreign players increased by about 50 percent in the Spanish La Liga, while the corresponding share in neighboring Italy was virtually unchanged. According to several sources, the Beckham Law influenced star player Cristiano Ronaldo to move from Manchester United to Real Madrid in 2009, at a time when the British government was planning to raise the top income tax rate from 40 percent to 50 percent. The Beckham Law has since been modified so that income exceeding €600,000 ($825,000) annually is taxed progressively.

Several other EU-countries, for instance Denmark, the Netherlands and Belgium, have introduced specific tax exemptions for highly skilled immigrants. Similar tax exemptions are also found in many countries outside the EU. In South Korea, for instance, a foreign engineer who meets certain criteria may get his or her income tax cut in half for a period of up to two years. Moreover, expatriate workers have the choice of paying a flat income tax rate of 18.7 percent, instead of the standard income tax which can be as high as 38 percent.

While talented individuals tend to be attracted to low marginal tax rates, new research suggests that the opposite may also be true. In an analysis of migration flows between 26 high-income countries and 23 developing countries, Assaf Razin and Jackline Wahba find evidence that the generosity of welfare systems tend to affect the skill-composition of immigrants. In other words, potential migrants with relatively low skills tend to be attracted to countries with generous welfare systems.

In recent years, a growing number of countries have focused on general reductions of top income tax rates rather than creating tax exemptions for talented foreigners. The number of countries that have introduced a flat income tax system (with the same tax rate applying to all income levels) has increased from nine in 2000 to over 40 today, of which seven are members of the EU. In Hungary, for instance, a progressive tax system with top income tax rates of 36 percent was replaced by a flat tax of 16 percent in 2012.

In the meantime, the United States seems to be moving in the opposite direction. The Obama administration and many leading Democrats are investing their political capital on increasing local and federal taxes on skilled workers and successful entrepreneurs. This will in all likelihood have a negative effect on the attractiveness of the U.S. labor market in the eyes of a highly skilled immigrant. The problem is augmented by rigidly restricted and badly backlogged skilled-worker permits such as H-1B visas.

The U.S. has long been a global magnet for talents. Close to half of the Nobel prizes given to U.S. scientists between 1901 and 1991 were given to foreign-borns or the children of foreign-borns. U.S. universities such as Stanford prosper by attracting the smartest and most ambitious brains from all over the world, something that likewise explains much of the success of technology clusters such as Silicon Valley. True, the U.S. still has the best academic institutions and some of the most competitive clusters in the world. But talents are mobile.

Those who today seek opportunities in the U.S. can easily instead choose other parts of the world that combine low taxes and high salaries with good employment opportunities. Canada and South Korea, for instance, have not only implemented significant tax reforms but are continuing to reduce the burden for successful individuals and firms.

Americans might be tempted to take their global advantage for given, but they should remember that Canada is increasingly seen as North America’s free-market success story. South Korea, on the other hand, was recently ranked as the most innovative country in the world by Bloomberg.

Returning to the metaphors of sports, since the U.S. Major League Soccer was founded in 1993, player quality as well as average salary has increased dramatically. Even though some might argue he had already passed the peak of his career, David Beckham did in fact play for the Los Angeles Galaxy between 2007 and 2012. The question is: Will the next Beckham be willing to move to the U.S.? And if the U.S. continues to move towards higher taxes for talents, whilst many competitors move in the opposite direction, will the future Beckhams be attracted to Los Angeles? Will other highly-skilled individuals?